Tipping the scales

New Morningstar rating says financial ETFs are value play

JohnSpence

BOSTON (MarketWatch) -- Morningstar Inc. has a new method of valuing exchange-traded funds that's warning against some popular market sectors and warming to neglected areas.

Specifically, the investment research firm concludes that energy and natural-resources ETFs appear pricey, but the financial services sector trades at a discount.

"We see financials ETFs as undervalued now," said Dan Culloton, a Morningstar analyst who covers ETFs, "and there are no big surprises for what we see as expensive: energy and natural resources."

Energy ETFs were about 11% to 13% overvalued at the end of April, while financials funds were about 9% to 11% undervalued, according to Morningstar's estimate of fair value of the underlying stocks.

The service leverages the Chicago-based firm's stock research to arrive at a forward-looking measure for funds.

The model takes Morningstar's fair-value estimates for the individual stocks in the ETF, determines a weighted average, and compares the result to the market price of the portfolio holdings.

The percentage difference between the two suggests whether the ETF is undervalued or overvalued according to Morningstar's research, and by how much.

"We now have between 75 and 80 equity analysts who are determining fair values for about 1,500 stocks based on fundamental analysis, discounted cash-flow models and research of business models," Culloton said.

So far the valuation measures have only been applied to large-capitalization stock ETFs, since that's where Morningstar's coverage is most extensive, he added.

Financials down but looking up

Financial services ETFs have plummeted this year on concern about higher interest rates and regulatory investigations that have hit some of the sector's largest components.

The Financial Select SPDR
XLF, -0.04%
which lost more than 3.6% this year through May 19, was undervalued by 10.7% at the end of April, according to Morningstar.

The ETF counts battered insurer American International Group, Inc.
AIG, +0.84%
as its third-largest holding, at 7.6% of assets.

The company is undergoing intense regulatory scrutiny and management changes. Yet Culloton said a strong argument can be made that AIG will regain its footing.

"Our analyst thinks there is a lot of bad news priced into the stock and that it's trading below what it's worth," he said.

Morningstar's fair value estimate for AIG is $80 a share; the stock closed Friday at $53.76.

Another top holding of the Financial Select SPDR is Morgan Stanley
MWD, -0.62%
which is enduring a public boardroom battle.

The broad market, as reflected by the S&P 500-tracking SPDR ETF Trust
SPY, -1.69%
also looks somewhat inexpensive. The ETF was undervalued by 4.3% at the end of April, according to Morningstar's measure.

Culloton said some of the largest blue-chips in the index, such as Walmart Stores Inc.
WMT, -0.93%
Microsoft Corp.
MSFT, -3.39%
and Dell Inc.
DELL
are trading at attractive valuations.

"Equities have gotten cheaper in recent months as the market has retreated," he said. "There are some large, high-quality companies out there with shares available at decent prices."

Overheated energy

Conversely, Morningstar is cautious about ETFs that focus on booming energy and natural resources stocks.

Natural resources funds have dipped recently, but are up 29.2% over 12 months through May 19, trailing only utilities and real-estate sector rivals, according to Morningstar.

At the end of April, the iShares Goldman Sachs Natural Resources
IGE, -0.35%
and the Energy Select SPDR
XLE, -0.03%
both looked to be overvalued by more than 13%, according to Morningstar.

That isn't surprising, Culloton said, because performance-chasing investors have pumped cash into energy stocks and funds.

Natural-resources funds posted net inflows of $5.6 billion in the first three months of the year, according to research firm Financial Research Corp.

Many market observers see fund flows as a contrarian indicator, since investors all too frequently pile into a hot sector just before a peak. Some energy funds, awash in cash, have closed their doors to new investors, including the $5.3 billion Vanguard Energy Fund
VGENX, -0.27%

Culloton noted the energy and natural resources ETFs would be even more overvalued if one the largest holdings, ExxonMobil Corp.
XOM, +0.33%
wasn't trading slightly below its Morningstar fair value estimate of $55 a share.

The oil giant represents about 7.5% of the iShares Goldman Sachs Natural Resources and is the Energy Select SPDR's top position at 20.3% of assets.

"Now is probably a dangerous time to chase the recent hot returns of the energy and materials sectors," Culloton said. "It's usually a bad idea to chase hot money, and natural-resources funds have been sizzling."

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